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Inflating European Expectations

The Wall Street Journal reported on 2/22/2017 that for the first time in almost four years, none of the Eurozone’s 19 member countries was in deflation during January. Aggregate Inflation across the region is now 1.8%, approaching the ECB’s (European Central Bank) target of 2.0%. The data is a notable marker that may be the signal for the ultra-accommodative ECB to reign in its QE (quantitative easing) program a little over two years since the Fed ended QE3 (3rd round of quantitative easing) in the fall of 2015. Such a move would have a profound effect on European currency rates with the U.S. fund flows follow real interest rates over the long term. With real interest rates higher in the United States than almost any developed economy, we believe it is a no brainer that money should flow into the dollar. As the Fed began raising rates at the end of 2015, it is no surprise that European currencies correspondingly declined substantially over the course of last year. The Fed’s most recent hike has put further pressure on the value of GBP, EURO, CHF and Kroners.

Enter the natural beauty of self-correcting global economics. Between 2011 and 2015 global foreign exchange markets were mind numbingly boring. During what – on the surface — appeared as a turbulent period in global economic history sterling and the euro traded within a very narrow range with the U.S. dollar. With virtually all central banks aligned behind hugely stimulate actions, transatlantic currencies traded largely in unison. In such circumstances with the United States ahead of the curve in terms of post crisis economic recovery the competitive advantage lay in North America. The turn in Fed policy at the end of 2015 broke that trend and 2016 served as a corrective year in terms of currency equalization.

The downdraft in European currency valuations has had the twin effect of boosting Europe’s competitive position and pushing up inflation as import prices increased. European markets have quietly taken note. Despite European equity performance in dollar terms once again falling behind the United States in 2016, in local terms, European equities had a strong year with aggregate performance reaching high single digits. For U.S.-based investors the benefits of increasing exposure to Europe are sweetened by the weak currencies and the opportunity to shop around for stock at attractive discounts. Wow, even a Big Mac in London is now 6% cheaper than in the United States…in London!

In the post crisis-era international markets have morphed into risk-on trades. Despite positive U.S.-based market returns, investors have remained jittery in recent years preferring assurance over risk. As global economic growth increases and a reflation trade gets underway the irony of a successful President Trump economy could likely be that international markets begin to outperform as risk appetite re-emerges and investors seek higher returns at reasonable valuations.

CRN: 2017-0302-5838R

Opinions in this piece are those of Cyrus J. Lawrence (CJL) and are not necessarily that of AAM.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.